14th August 2023

Ten Investment Beliefs for the Second Half of 2023

The latter part of 2023 could mark a crucial turning point for the worldwide economy. Inflation pressures are subsiding, and the risks are transitioning towards a focus on growth. Although major economies are still managing to steer clear of recession, the resilience of the services sector contrasts with weakening manufacturing indicators. While headline inflation is on a downward trend, the data excluding energy is proving to be more resistant to change. Concerns about potential contagion from US regional banks in March have now faded, and the tightening of lending conditions turned out to be less severe than initially feared.

Alongside the tight labour markets and robust consumer expenditure, these patterns provide central banks with room and motivation to sustain their cautious monetary policies. Nonetheless, the conclusion of the phase of interest rate hikes is drawing near. Central banks will maintain elevated rates and might even raise them further if necessary, until the economic pace moderates. Hence, it's unlikely that the Federal Reserve will ease its monetary policies before the beginning of 2024. Our attention is closely attuned to the repercussions on small businesses and their workforce, which constitute the majority of economic production and labour force. We anticipate that any recession in the US would be both minor and brief, with GDP growth projected at 0.9% for the entire year.

Turning to Europe, the effects of the energy shock have subsided, and core inflation has only just begun its descent, while wages continue their upward trajectory. We foresee the European Central Bank persisting with its series of interest rate hikes, amidst a sluggish economic expansion of 0.7% in 2023. Meanwhile, China's recovery post-pandemic has progressed at a slower pace than anticipated, and vulnerabilities persist in the real estate sector. However, inflation remains under control, and consumer spending remains stable, thanks to China's authorities upholding their supportive measures. Our projection is that China's economy will achieve a growth rate of 5.5% throughout 2023.

Globally, investor sentiment towards risk has been on the upswing due to a slowdown in inflation. However, as economic growth also decelerates and the surge in equity markets this year is heavily influenced by the performance of large-cap stocks and the technology sector, we are maintaining a well-balanced investment stance. Our approach remains neutral in terms of risk assets, with a focus on areas that offer a greater safety margin or a more robust growth outlook. This strategy helps to counterbalance the mix of economic data and tightening credit conditions, even as valuations in risk assets seem to align with a gentle economic slowdown.

Nevertheless, given the looming risk of a recession, the equilibrium between risk and reward in the equity markets doesn't seem particularly compelling. The increase in the cost of capital will exert pressure on corporate growth and earnings in the United States. We anticipate an 8% decline in earnings growth for the S&P 500 index over the entire year, followed by a 13% rebound in 2024. In contrast, European earnings are projected to rise by 13% in 2024, while both Japan and China are expected to see a 15% increase.

Following a decade marked by low to negative interest rates, high-quality fixed income options are once again delivering attractive returns. At this stage of the economic cycle, we express a preference for government and investment-grade corporate bonds.

While exploring potential opportunities, it is essential to meticulously monitor the associated risks, especially in light of the most profound tightening of monetary policies in decades. The perils of persistent inflation and potential missteps in monetary policy remain significant concerns, alongside the possibility of tighter credit affecting the broader economy and heightened geopolitical tensions. Moreover, there's a possibility of a sharp dip in corporate earnings or the markets underestimating the probability of a recession

Within this publication, we outline our ten most robust investment convictions and portfolio principles as we gaze ahead into the remainder of 2023 and beyond.

1. Yield and Diversification from Long-Dated Bonds

We find appeal in long-dated government bonds, primarily in the 5-to-10 year range. Our focus is particularly on US Treasuries, followed by German Bunds and shorter-term UK government gilts. Our rationale rests on the anticipation of a growth slowdown and peaking interest rates. The allure of higher yields enhances the attractiveness of sovereign debt, and the diversification potential of government bonds becomes pertinent in the case of a more pronounced economic deceleration. This renders these assets a valuable inclusion in portfolios. Historically, government bonds tend to outperform cash once rates have reached their zenith.

2. Preference for Higher-Quality Segments in Developed Credit Markets

We hold a preference for investment grade credit due to its current competitiveness with equities, a scenario not witnessed for quite some time. Our attention is geared towards the higher-quality segments within developed credit markets, particularly focusing on 3-to-5-year European credit issuers. In the realm of high yield, valuations appear elevated compared to historical benchmarks, possibly misaligned with the prospective credit risk given the context of slowing growth and sustained high interest rates during the latter half of the year.

3. Favoring Emerging Market Local Currency Bonds over Hard Currency Bonds

Emerging market local currency debt offers an avenue for returns and diversification due to favorable local interest rates and currencies. We show favor towards markets boasting high carry yields. As for emerging market hard currency bonds, we maintain a cautious stance due to seemingly inflated valuations amidst macroeconomic uncertainties. Our attention pivots towards Brazilian government bonds, providing an attractive yield compared to both developed and other emerging markets, coupled with potential gains stemming from future interest rate reductions.

4. Preference for Quality Stocks and Non-US Markets

While the potential for gains in equities remains, it hinges significantly on earnings and the depth of any impending recession. Our focus lies in three pivotal aspects: the trajectory of earnings recovery, the cessation of rate hikes, and the broadening of market returns beyond the technology sector that has driven performance throughout 2023. Our inclination is directed towards markets outside the US, particularly Europe, Japan, and China. China, in particular, harbors untapped potential, juxtaposed against accumulated investor pessimism. Defensive sectors hold greater promise than cyclicals, which already factor in a potential resurgence in economic activity. Quality stocks tend to outperform in uncertain scenarios, aligning well with an active investment management approach. We channel our focus towards earnings compounders and pricing power, recognizing that valuations for such enterprises might seldom be inexpensive but remain justifiable.

5. Commodities Offer Portfolio Opportunities

We hold the belief that gold can navigate ongoing economic challenges tied to prolonged elevated interest rates, potentially witnessing an ascent to USD 2,100 per ounce by early 2024. This upward trajectory could be propelled by a peak in US real rates, a weakening US dollar, and robust demand from investors, central banks, and consumers. In the short term, the decisions made by the Federal Reserve will exert influence on gold prices. Furthermore, energy and copper stand to benefit from medium-term support due to restricted supply driven by emerging market demand and the transition towards sustainable energies.

6. Strength of Swiss Franc, Euro, and Japanese Yen Against the Dollar

Currency dynamics exhibit significant divergence. The US dollar's likelihood of further depreciation, particularly against the Swiss franc, euro, and Japanese yen, looms large. We adopt a cautious stance on currencies sensitive to global growth and characterized by lower yields, encompassing the Chinese renminbi. In contrast, we express preference for emerging markets like the Brazilian real, which offers substantial carry yield, leveraging a backdrop of diminishing inflation and improving fiscal and external balances.

7. Leveraging Volatility for Diverse Income Streams

Volatility metrics across diverse asset classes have largely normalized. This normalization can be harnessed by investors to generate supplementary income and extend diversification across exposures. Additionally, alternative hedge fund strategies, encompassing macro and trend-following approaches, hold allure due to the broader range of returns witnessed within and across asset classes during the latter phases of an economic cycle. Hedge fund strategies centered on long/short positions and distressed credit also emerge as increasingly enticing ways to position portfolios amidst market upheavals.

8. Thematic Investments for Long-Term Returns

Thematic investments serve as a valuable avenue for augmenting portfolio returns, leveraging steadfast, secular trends to enhance diversification and risk mitigation. Currently, the transition towards climate-conscious practices emerges as an appealing long-term opportunity, particularly within electrification, nature-oriented investment solutions, and technologies aligned with global climate objectives.

9. Role of Private Assets in Portfolio Diversification

For eligible investors endowed with a suitable time horizon and the capacity to tolerate illiquid investments, private assets emerge as pivotal constituents of a diversified portfolio. This asset class provides access to segments of the economy beyond the reach of public markets, encompassing nascent technologies and early-stage enterprises, all while fostering diversification and potentially heightened returns. Concurrently, the backdrop of elevated rates, and in some cases, the potential to acquire assets at lower valuations in certain private equity strategies, presents opportunities for present-day investors with deployment envisioned over the subsequent 6-12 months.

10. Guiding Principles for Late-Cycle Investing

To ensure the robustness of portfolios, we seek assets offering a margin of safety. This principle necessitates an agile and proactive investment approach to asset allocation and risk management. The degree of exposure to risk assets is contingent upon the prevailing stage of the economic cycle. In the late stages, inadequate allocation could lead to suboptimal portfolio outcomes as potential growth areas and rebounds might be overlooked. Additionally, a consistent investment posture is imperative over a suitable time horizon, enduring short-lived bouts of volatility as economies adjust to ever-evolving conditions. Crucially, the ongoing transformation in the global economic landscape, alongside substantial capital investments in innovation and novel technologies, elevates sustainability as a pivotal long-term driver of investment returns.